Over the last couple of years, most investors would agree that there hasn't been a single topic that has attracted more attention than inflation. Following the worst days of the pandemic, prices across the economy at one point were rising at the fastest pace in about 40 years. This was a development that probably surprised everyone.
Inflation was something we didn't really think too much about due to it being a non-issue since the end of the Great Recession. But these days, even though it's showing signs of cooling down somewhat, inflation is something all investors should understand.
We have no power to control what happens with inflation, but we have total influence over what we can do about it. And that means we can position our portfolios to better deal with inflation uncertainty.
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An interesting economic topic
Inflation isn't anything unusual. In fact, it's a normal occurrence. The Federal Reserve explicitly targets a 2% annualized inflation rate for the U.S., which is what it views as being indicative of a healthy economy.
A valid question to wonder is why even such a small rate of inflation is necessary. Just imagine if there were no inflation. Consumers wouldn't be incentivized to spend, given that the money they keep wouldn't be losing value. But because spending is such a massive part of our economy, central bankers want to encourage it, so a 2% inflation target is put in place.
The latest measure of the Consumer Price Index showed a 3.7% year-over-year increase in August. That was down substantially from the print exactly a year earlier. While it's hard to pinpoint exactly what has caused high inflation in recent years. Economists can blame unprecedented amounts of government stimulus throughout the pandemic, a boom in consumer demand following curtailed spending, and supply chain issues.
How to play inflation uncertainty
I don't think anyone has any clue where inflation is headed next, even the Federal Reserve. So, from an investment perspective, the best course of action is to identify companies that have pricing power. This is Warren Buffett's favorite characteristic to look for, and it shows that a business can successfully increase what it asks its customers to pay with minimal impact on demand. When inflation strikes, these companies are well-positioned to thrive.
It's not too difficult to find these types of businesses. In the restaurant sector, Chipotle Mexican Grill immediately comes to mind. The popular Tex-Mex chain has implemented numerous price hikes in the past couple of years to offset rising costs for labor, food, and paper products. But demand remains robust. Revenue was up 14% in 2022 and 15% through the first six months of this year, with margins continuing to expand.
You might not believe that Etsy has pricing power. However, the fee that it charges sellers was bumped up in April 2022. The number of sellers on the platform has actually gone up, which shows just how valuable they view the online marketplace. This shows up in Etsy's take rate, a figure that increased to 20.9% in the latest quarter (the second quarter of 2023, ended June 30). And with shares trading at a ridiculously cheap forward price-to-earnings ratio of 13.4, investors might want to act quickly.
Owning shares in card payment giants Visa and Mastercard could also be a smart idea. Because these companies collect assessment fees that are charged as a percentage of the overall transaction dollar amount, anytime consumers are asked to pay more due to inflation, and one of their cards gets swiped, the potential is there to earn higher revenue. Some might call Visa and Mastercard inflation-proof businesses. And with their tremendous operating margins and ability to produce lots of free cash flow, they can be foundational holdings in one's portfolio.
